Options Settlement: A Comprehensive Guide

Options settlement is a crucial process for investors to understand. It involves the transfer of ownership of an option contract from the buyer to the seller, and it's typically done on the third Friday of each month.

The settlement process usually takes place on the third Friday of the month, regardless of the market's schedule. This ensures a standardized and consistent process for all investors.

To settle an options contract, the buyer must pay the seller the difference between the strike price and the market price of the underlying asset. This is known as the premium.

The premium is typically paid in cash, but it can also be paid in kind, where the buyer delivers the underlying asset to the seller.

There are two main types of options settlement: physical and cash settlement. Physical settlement involves the transfer of the underlying asset from the seller to the buyer.

A cash-settled option, on the other hand, avoids the high costs of transport or transaction fees, making it a more convenient option for some investors. This type of option settles in a cash payment, rather than actual physical delivery of the underlying asset.

Many options contracts today are cash-settled, but there are some exceptions. Listed equity options contracts, for example, are settled by delivery of the actual underlying shares of stock.

Cash-settled options typically have a European style, where the holder may only exercise the option contract at expiration. This is in contrast to American options, which can be exercised early.

The vast majority of exercises are automatically carried out based on the closing settlement price on the contract expiration date. This means that if the option is out of the money on the expiration date, it will have no value and there will be no exercise taken place.

Choosing the right settlement option depends on several factors, including financial needs and circumstances.

The policyholder or their beneficiaries' financial needs play a crucial role in determining the most suitable settlement option. For instance, a lump-sum payment might be appropriate if there are immediate financial obligations to meet.

A lump-sum payment can provide immediate financial relief, but it may not be suitable for ongoing expenses. Installment payments or an annuity could provide a steady income stream for ongoing expenses.

In the case of stock options, the vast majority of exercises are automatically carried out based on the closing settlement price on the contract expiration date.

If an option is out of the money on the expiration date, it will have no value and there will be no exercise taken place; if the moneyness of the option is equal to or higher than $0.01, the option will be automatically exercised.

As the option seller, if your account is assigned, you must either deliver the underlying stock or buy the underlying stock. The option clearing house will randomly match the open short position with the exercised option.

Tax implications of options settlement can be complex. A lump-sum payment can push the recipient into a higher tax bracket for the year.

Installment payments, on the other hand, can spread out the tax liability over several years. This can be beneficial for individuals who want to minimize their tax burden.

It's essential to consider the tax implications of each settlement option carefully.

Tax implications can be a major consideration when it comes to settlement options. A lump-sum payment can push the recipient into a higher tax bracket for the year.

This can result in a larger tax liability. The recipient may need to pay more in taxes, which can be a significant financial burden.

Installment payments, on the other hand, can spread out the tax liability over several years. This can help reduce the tax burden in the short-term.

It's essential to consider the tax implications of each settlement option carefully. This can help ensure that the chosen option is the most tax-efficient choice.

Close-to-Expiry options have a higher margin requirement because they are within 5 trading days to expiry.

This means your option position may undergo significant changes on the expiration day, such as being exercised or assigned, which can lead to a substantial cash requirement.

If you have a long call position that is exercised, it will become a long position of the underlying stock, and the account will deduct the cash required to establish the position.

To manage this risk, Moomoo Financial Inc. starts calculating the margin and settlement requirements for options that are in-the-money or close to in-the-money on the day of expiration, usually 3 hours before market close.

This is done to ensure customers have sufficient liquidity for option exercise, and not having enough funds can lead to the account being marked as "dangerous" from a risk control perspective.

If your account is marked as "dangerous", Moomoo Financial Inc. may perform actions such as liquidating your option positions, waiving your right to option exercises, or executing the option exercise and closing the corresponding stock positions afterwards.

The benefits of cash-settled options are numerous, and they can be a game-changer for investors.

One of the main advantages is that they allow buyers and sellers to speculate on a market without worrying about actually buying or selling in the spot market. This is especially useful for index options, which can be a hassle to deal with.

Reducing the overall time and costs required during a contract's finalization is another significant benefit. Cash-settled contracts are relatively simple to deliver because they require only the transfer of money.

This can save investors a lot of time and money, especially when compared to physical delivery, which comes with added costs like transportation and delivery quality verification.

Cash settlement also safeguards against default, as it requires margin accounts that are monitored daily to ensure they have the required balances.

This added layer of protection gives investors peace of mind and helps prevent costly mistakes.

Exercising an option can be a straightforward process, but there are some key things to keep in mind. If you're the option purchaser, the vast majority of exercises are automatically carried out based on the closing settlement price on the contract expiration date.

If the option is out of the money on the expiration date, it will have no value and won't be exercised. However, if the moneyness of the option is equal to or higher than $0.01, it will be automatically exercised, resulting in the physical delivery of the underlying shares.

As the option seller, you'll need to be prepared for the possibility of being assigned if the option is exercised by the purchaser. This means you'll need to either deliver the underlying stock (if it's a call option) or buy the underlying stock (if it's a put option).

Stock options can be exercised in two main ways: automatic exercise and manual exercise.

The vast majority of exercises are automatically carried out based on the closing settlement price on the contract expiration date.

If an option is out of the money on the expiration date, it will have no value and there will be no exercise.

In-the-money options, on the other hand, are exercised when they expire. If you are short an in-the-money option on the expiry date, you will most likely be assigned.

The value of an in-the-money option goes to zero when exercised, and a position of the underlying stock is opened at the exercise price.

To exercise an option, you'll need to have enough funds in your account to cover the initial margin requirement, which is typically 50% of the underlying stock's value.

For example, if you're exercising an in-the-money option for 100 shares of FUTU, the initial margin requirement would be $10,000, assuming a 50% margin requirement.

If your account is deemed "insufficient" in funds, you'll need to make up the difference to ensure a successful option exercise.

In the case of a short equity call, the seller of the option must deliver stock at the strike price and receive cash in return.

Similarly, in the case of a short equity put, the seller of the option is required to purchase the stock at the strike price.

Cash-settled options, on the other hand, do not require physical delivery of the underlying asset and are settled in cash instead.

Early exercise of options can be a viable strategy, but it's generally less profitable than selling out of the position.

Forgetting about the profit, exercising an option early can be necessary when it's deep in-the-money, especially if poor liquidity makes it hard to close the position at a reasonable price.

Exercising a call option early can also make sense if you want to receive dividends from the underlying shares before the ex-dividend date.

If you exercise an in-the-money put option, you'll end up with a short position of the underlying stock.

In such cases, exercising early might be the better option, even if it's less profitable.